AO World may be the right company at the wrong time

5 mins. to read
AO World may be the right company at the wrong time

When it comes to investing, it seems as though timing is everything. Even the best stocks can have their bad days. And the ‘dogs’ of the index can enjoy periods of stunning share price growth. Therefore, finding the right stocks at the right time seems to be the difference between success and failure in investing.

At the moment, I think it’s the wrong time to buy highly-rated retail stocks. The UK economy faces an unprecedented risk from Brexit. Already, the pressure caused by higher inflation is starting to affect the outlook for consumers. More could be ahead, according to the Bank of England. It reduced its UK GDP growth forecast from 2% to 1.9% last week. Notably, this assumes a smooth Brexit process.

Of course, cheap retailers could be sound contrarian buys. The problem is when a stock in a precarious financial position and with a high valuation encounters difficulties. This could be the medium-term future facing electrical appliances retailer AO World (LON:AO). It remains loss-making, has a high prospective valuation and could experience difficult trading conditions if consumers become increasingly price conscious.

A changing outlook

The outlook for retailers such as AO World has changed dramatically in the last year. Back then, wage growth easily outstripped inflation. That was not too difficult, since CPI inflation was only 0.7% in April 2016. This meant that consumers were seeing their real disposable incomes rise year-on-year, which meant they had more to spend on consumables. As a result, they were gradually becoming less price-conscious and more interested in convenience, quality and customer service. This provided scope for margin improvements, as well as higher sales, for retailers such as AO World.

Now, though, the outlook for retailers is changing at a rapid rate. Inflation is 2.7% versus 2.2% for wage growth. This situation is likely to worsen, since UK GDP growth is now forecast to be 1.9% in 2017. More downgrades to this figure from the Bank of England could lie ahead, since it has assumed a smooth Brexit process. If the rumoured frosty nature of meetings between the UK and EU thus far is anything to go by, the Brexit process may be rough, rather than smooth. In this scenario, UK GDP growth may fall and lead to slower wage growth.

At the same time, inflation is forecast to rise to 3% or even 4% by the end of 2018. If Brexit talks equal uncertainty in the UK economic outlook, confidence may decline and sterling could depreciate. This could drive inflation higher and lead to even more difficult trading conditions for retailers such as AO World.

A changing consumer

As mentioned, a year ago consumers were enjoying rising real disposable incomes. Now, though, they have less to spend on a real basis than they did a year ago. The effect of this is likely to be increasingly price-conscious behaviour. For example, they are likely to seek to trade down on price for a range of items. Retailers may be forced to either invest in pricing and accept lower profitability, or maintain prices and accept lower levels of sales.

Retailers may be forced to either invest in pricing and accept lower profitability, or maintain prices and accept lower levels of sales.

Perhaps the most dangerous aspect of a situation where inflation exceeds wage growth for a period of time, though, is the effect it has on consumer confidence. For example, after the financial crisis of 2007-09 had ended, it took a number of years for consumers to feel confident enough to buy higher-priced items. It could even be argued that the era of the price-conscious consumer never really ended, with discount stores such as Aldi and Lidl still popular.

Similarly, many finance programmes and column inches are still dedicated to saving money, which is clearly not a healthy situation for retailers such as AO. They would rather consumers focused on their service levels, convenience and other differentiators, rather than basing their decisions on price. Therefore, even if wage growth lags inflation for a relatively short time, the effects of it could be prolonged.

A difficult outlook

All of these changes are occurring at a key point for AO World. It is reinvesting the profits made in its UK operations in expansion into Germany and the Netherlands. Both of these territories are loss-making for the company at the moment. They are reliant on the performance of the UK business, as well as fundraisings such as the recent placing of 10% of the company’s share capital. Therefore, if the UK economic outlook deteriorates and AO World’s UK profitability declines, its operations in Germany and the Netherlands may struggle to receive sufficient capital to grow at their forecast pace.

A further problem AO World may encounter is a decline in the importance placed on customer service by consumers. Normally, I would praise AO World’s focus on delivering exceptional customer service, because I believe it is the most successful means of differentiating one company from another. It can lead to higher margins in the long run, as well as more repeat business. However, with customers now starting to find their pay packets do not go as far as they did a year ago, they may prioritise price over customer service. This may leave AO World being forced to invest more in pricing and less in customer service over the medium term.

Looking ahead

As mentioned, retailers with low valuations could be worth buying at the moment. Their share prices may fully reflect the challenges which the UK economy faces. However, in the case of AO World, it is a loss-making business which is forecast to move into profitability in financial year 2019. With its shares having a prospective P/E of 84 using financial year 2019’s forecast EPS, they seem to have a relatively small margin of safety.

Therefore, while AO World’s focus on customer service and its growth strategy would normally be sufficient reasons to buy it, now does not seem to be the right time to do so. The outlook for the UK economy and for UK consumers is deteriorating and this could cause major challenges for the company in the short-to-medium term. As is sometimes the case with investing, AO World seems to be the right company at the wrong time given the outlook for its operating environment.

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